Large cap US equities managed to deliver another year of double-digit performance. Since the market bottom on March 9, 2009 the S&P has returned 22.3% annualized for a total gain of 210%. Earnings over that period grew at an annual rate of 11%, with most of the growth coming in 2009 and 2010. Since 2010, S&P 500 earnings growth has slowed to just under 8%. P/E expansion accounted for nearly half of the index return in 2014. A 22% increase in the P/E ratio of the Russell 2000 Small Cap Index was offset by a 15% decline in earnings. Outside the US, P/E ratios contracted. This, along with a strengthening dollar and flat earnings, led to the poor performance of foreign stocks. Multiple expansion was most notable among high dividend stocks with Utilities and Real Estate Investment Trusts both returning nearly 30% for the year. Resurgence in new drug pipelines drove performance in the Healthcare sector. Apple, Microsoft, Intel and Facebook accounted most of the out-performance of the Technology sector. Declining oil prices during the second half of the year erased what had been strong performance from the Energy sector and left it with a 7.8% decline for the year.

Most of the equity market performance since the recovery from the Financial Crisis began in 2009 can be viewed as a reduction in the discount rate which is applied to future earnings. Falling discount rates equate to a rising P/E ratio. The equity discount rate consists of two components – a normal interest rate which is tied to Treasury yields and a risk premium which is the additional return investors require to invest in stocks. Both of these components have fallen since 2009, providing a substantial boost to equity returns. The risk today is that these discount rates are finding a lower bound and may increase in the future. The timing and magnitude of a future increase is uncertain and there are no guarantees that these rates will rise at all. As these discount rates apply to all financial assets, some combination of increases in risk-free rates and risk premiums constitutes the most significant fundamental risk to investors today.

Equity Valuations are tied to Discount Rates

Most investors understand how bond prices and yields are inversely correlated – a reduction (increase) in bond price translates into higher (lower) future returns. The same principle applies to stocks – a lower (higher) P/E ratio results in higher (lower) future returns. This principle can be clarified by inverting the P/E ratio to provide a yield metric. A P/E ratio of 20 translates to a 5% earnings yield. If the P/E ratio increases to 25, the earnings yield has fallen to 4%. With a properly managed company shareholders should receive the economic benefit of all a company’s earnings – not just the portion used for dividends or share buybacks. Earnings not distributed to investors will generally be used to fund new growth projects which will increase future dividends and share buybacks. There is a theorem in finance which states that the value of a stock is unchanged by what portion of earnings management decides pay out in dividends. While real life is messier than the simplified assumptions used in academic finance, this remains a useful principle. Future stock returns are tied to the current earnings yield plus future growth in earnings.

Impact of a 300 Basis Point Increase in Interest Rates on Treasury Bonds

Bond cash flows, barring a default, are certain. Equity earnings are volatile, rising and falling with the business cycle. A useful metric to smooth these peaks and troughs in earnings is to take a long term average. The methodology began by Robert Schiller at Yale is the most commonly used. It averages earnings over a trailing ten year period – long enough to contain the peaks and troughs of the cycle. These earnings are inflated into current purchasing power. Calculating an earnings yield using this metric provides a reasonable estimate of future stock returns (net of inflation) which is also a proxy for equity discount rates. For the S&P 500 this yield currently stands at around 4.5%, so if inflation continues to average 2.5%, a 7.0% return can be expected from large cap stocks. If this yield were to increase to 6%, which is more in line with historical averages, stock prices would fall by 25%, but future returns would be higher. This is analogous to what happens to a long term bond when interest rates increase. Stocks are more complex, having volatile cash flows and two components to their discount rate – the risk free rate plus a risk premium. Despite this additional complexity, it can still be fruitful, particularly at a portfolio level, to think about duration in regards to stocks, not just relative to fixed income.

Bond Duration Explained

With bonds (and without getting too precise), duration is both the weighted maturity of cash flows and the first derivative of a bond price with respect to a change in interest rates. The simplest instrument is a zero-coupon bond, which pays no coupons but just a lump sum at maturity. In this case the duration is equal to the maturity. The duration of a coupon-paying bond will be less than its maturity with higher coupon rates translating to lower durations. As duration is also the first derivative, it is a good approximation of the change in price resulting from a small change in interest rates. Most importantly for this piece, duration also represents the holding period where an investor can be assured to receive a return equal to the purchased yield. This is obvious with zero-coupon bonds – if a ten year zero is purchased at the current 2.1% yield and held to maturity, the return will be 2.1% regardless of what happens to interest rates over the ten years. The return of a coupon-paying bond will equal the duration if the coupons are reinvested. The duration of a current coupon-paying ten year Treasury bond is 8.8 years, slightly less than the ten year maturity. If the coupons are reinvested, an investor is guaranteed to receive the current yield to maturity of 1.9% over the 8.8 year time period. Duration also applies to bonds without maturities. The UK has issued perpetual government bonds which nonetheless have a finite duration of 20-30 years, depending on the coupon rate (the formula is (1+discount rate) / discount rate). Similarly, as they do not have a finite maturity, stocks also have a duration in the 20-30 year range.

Stocks are a Long Duration Asset

This concept of equity duration’s importance stems from today’s low return environment as it gauges the downside risk if discount rates revert to levels more in line with historical norms. If large cap US stocks today are priced to return 4.5% plus inflation and then fall 25% so they are priced to return 6% plus inflation then it will take approximately 20 years at the new 6% real return rate for the equity investor to get back to a 4.5% annualized real return.

This is the essence of duration risk – one invests today at a particular discount rate and after the investment is made the discount rate increases. The only way, short of a crystal ball, to protect capital from this is to match the durations of assets with the duration of liabilities. For portfolios where the intent is to effectively manage in perpetuity, the duration of liabilities can be calculated as (1+distribution rate) / distribution rate. So the duration of the liabilities of a portfolio with a 4% distribution rate would be 1.04/.04 = 26 years. Ignoring the distant future by capping the stream of distributions at 35 years reduces the duration to 18.6 while a 20 year stream of distributions has a duration of 13.6 years. If the S&P 500 has a duration of 20 years and a typical intermediate term bond portfolio has a duration of 5 years then a portfolio of 70% stocks and 30% bonds has an overall duration of 15.5 years. The point is not to calculate duration with the accuracy employed by bond managers, rather to think about how long it will take for a portfolio to overcome an increase in discount rates.

Why this Matters

Much of the arguments about the merits of active management and alternative investments relative to index funds take on a new light in the context of duration. Active strategies and alternatives can reduce a portfolio’s sensitivity to changes in discount rates. Absolute value strategies that can carry significant cash positions during periods like this where finding undervalued stocks is difficult have implicitly lower durations. Hedge fund strategies are characterized by a lower duration than a long equity position, either because part of the long position is hedged, or there is some short term event that will result in the realization of value and an exit from the position. Managed futures, uniquely, has no relationship to changes in discount rates. Higher yielding investments are less sensitive to discount rates.

Since the early 1980s, exposure to duration, whether in stocks or bonds, has paid handsomely. With discount rates finding a lower bound, the potential gains from duration exposure are limited to the current spread over shorter term rates. A return to higher discount rates for stocks and bonds would result in a painful loss of value and a lengthy recovery period. Investors can mitigate these risks through exposure to particular active strategies and alternative investments. Comstock’s goal in this environment is to advise clients on developing a mix of strategies and exposures that best suits their financial goals and risk temperament.

– By Stephen C. Browne, CFA
Chief Investment Officer

## Risks of a Low Return Environment

Large cap US equities managed to deliver another year of double-digit performance. Since the market bottom on March 9, 2009 the S&P has returned 22.3% annualized for a total gain of 210%. Earnings over that period grew at an annual rate of 11%, with most of the growth coming in 2009 and 2010. Since 2010, S&P 500 earnings growth has slowed to just under 8%. P/E expansion accounted for nearly half of the index return in 2014. A 22% increase in the P/E ratio of the Russell 2000 Small Cap Index was offset by a 15% decline in earnings. Outside the US, P/E ratios contracted. This, along with a strengthening dollar and flat earnings, led to the poor performance of foreign stocks. Multiple expansion was most notable among high dividend stocks with Utilities and Real Estate Investment Trusts both returning nearly 30% for the year. Resurgence in new drug pipelines drove performance in the Healthcare sector. Apple, Microsoft, Intel and Facebook accounted most of the out-performance of the Technology sector. Declining oil prices during the second half of the year erased what had been strong performance from the Energy sector and left it with a 7.8% decline for the year.

Most of the equity market performance since the recovery from the Financial Crisis began in 2009 can be viewed as a reduction in the discount rate which is applied to future earnings. Falling discount rates equate to a rising P/E ratio. The equity discount rate consists of two components – a normal interest rate which is tied to Treasury yields and a risk premium which is the additional return investors require to invest in stocks. Both of these components have fallen since 2009, providing a substantial boost to equity returns. The risk today is that these discount rates are finding a lower bound and may increase in the future. The timing and magnitude of a future increase is uncertain and there are no guarantees that these rates will rise at all. As these discount rates apply to all financial assets, some combination of increases in risk-free rates and risk premiums constitutes the most significant fundamental risk to investors today.

## Equity Valuations are tied to Discount Rates

Most investors understand how bond prices and yields are inversely correlated – a reduction (increase) in bond price translates into higher (lower) future returns. The same principle applies to stocks – a lower (higher) P/E ratio results in higher (lower) future returns. This principle can be clarified by inverting the P/E ratio to provide a yield metric. A P/E ratio of 20 translates to a 5% earnings yield. If the P/E ratio increases to 25, the earnings yield has fallen to 4%. With a properly managed company shareholders should receive the economic benefit of all a company’s earnings – not just the portion used for dividends or share buybacks. Earnings not distributed to investors will generally be used to fund new growth projects which will increase future dividends and share buybacks. There is a theorem in finance which states that the value of a stock is unchanged by what portion of earnings management decides pay out in dividends. While real life is messier than the simplified assumptions used in academic finance, this remains a useful principle. Future stock returns are tied to the current earnings yield plus future growth in earnings.

## Impact of a 300 Basis Point Increase in Interest Rates on Treasury Bonds

Bond cash flows, barring a default, are certain. Equity earnings are volatile, rising and falling with the business cycle. A useful metric to smooth these peaks and troughs in earnings is to take a long term average. The methodology began by Robert Schiller at Yale is the most commonly used. It averages earnings over a trailing ten year period – long enough to contain the peaks and troughs of the cycle. These earnings are inflated into current purchasing power. Calculating an earnings yield using this metric provides a reasonable estimate of future stock returns (net of inflation) which is also a proxy for equity discount rates. For the S&P 500 this yield currently stands at around 4.5%, so if inflation continues to average 2.5%, a 7.0% return can be expected from large cap stocks. If this yield were to increase to 6%, which is more in line with historical averages, stock prices would fall by 25%, but future returns would be higher. This is analogous to what happens to a long term bond when interest rates increase. Stocks are more complex, having volatile cash flows and two components to their discount rate – the risk free rate plus a risk premium. Despite this additional complexity, it can still be fruitful, particularly at a portfolio level, to think about duration in regards to stocks, not just relative to fixed income.

## Bond Duration Explained

With bonds (and without getting too precise), duration is both the weighted maturity of cash flows and the first derivative of a bond price with respect to a change in interest rates. The simplest instrument is a zero-coupon bond, which pays no coupons but just a lump sum at maturity. In this case the duration is equal to the maturity. The duration of a coupon-paying bond will be less than its maturity with higher coupon rates translating to lower durations. As duration is also the first derivative, it is a good approximation of the change in price resulting from a small change in interest rates. Most importantly for this piece, duration also represents the holding period where an investor can be assured to receive a return equal to the purchased yield. This is obvious with zero-coupon bonds – if a ten year zero is purchased at the current 2.1% yield and held to maturity, the return will be 2.1% regardless of what happens to interest rates over the ten years. The return of a coupon-paying bond will equal the duration if the coupons are reinvested. The duration of a current coupon-paying ten year Treasury bond is 8.8 years, slightly less than the ten year maturity. If the coupons are reinvested, an investor is guaranteed to receive the current yield to maturity of 1.9% over the 8.8 year time period. Duration also applies to bonds without maturities. The UK has issued perpetual government bonds which nonetheless have a finite duration of 20-30 years, depending on the coupon rate (the formula is (1+discount rate) / discount rate). Similarly, as they do not have a finite maturity, stocks also have a duration in the 20-30 year range.

## Stocks are a Long Duration Asset

This concept of equity duration’s importance stems from today’s low return environment as it gauges the downside risk if discount rates revert to levels more in line with historical norms. If large cap US stocks today are priced to return 4.5% plus inflation and then fall 25% so they are priced to return 6% plus inflation then it will take approximately 20 years at the new 6% real return rate for the equity investor to get back to a 4.5% annualized real return.

This is the essence of duration risk – one invests today at a particular discount rate and after the investment is made the discount rate increases. The only way, short of a crystal ball, to protect capital from this is to match the durations of assets with the duration of liabilities. For portfolios where the intent is to effectively manage in perpetuity, the duration of liabilities can be calculated as (1+distribution rate) / distribution rate. So the duration of the liabilities of a portfolio with a 4% distribution rate would be 1.04/.04 = 26 years. Ignoring the distant future by capping the stream of distributions at 35 years reduces the duration to 18.6 while a 20 year stream of distributions has a duration of 13.6 years. If the S&P 500 has a duration of 20 years and a typical intermediate term bond portfolio has a duration of 5 years then a portfolio of 70% stocks and 30% bonds has an overall duration of 15.5 years. The point is not to calculate duration with the accuracy employed by bond managers, rather to think about how long it will take for a portfolio to overcome an increase in discount rates.

## Why this Matters

Much of the arguments about the merits of active management and alternative investments relative to index funds take on a new light in the context of duration. Active strategies and alternatives can reduce a portfolio’s sensitivity to changes in discount rates. Absolute value strategies that can carry significant cash positions during periods like this where finding undervalued stocks is difficult have implicitly lower durations. Hedge fund strategies are characterized by a lower duration than a long equity position, either because part of the long position is hedged, or there is some short term event that will result in the realization of value and an exit from the position. Managed futures, uniquely, has no relationship to changes in discount rates. Higher yielding investments are less sensitive to discount rates.

Since the early 1980s, exposure to duration, whether in stocks or bonds, has paid handsomely. With discount rates finding a lower bound, the potential gains from duration exposure are limited to the current spread over shorter term rates. A return to higher discount rates for stocks and bonds would result in a painful loss of value and a lengthy recovery period. Investors can mitigate these risks through exposure to particular active strategies and alternative investments. Comstock’s goal in this environment is to advise clients on developing a mix of strategies and exposures that best suits their financial goals and risk temperament.

## – By Stephen C. Browne, CFA

Chief Investment Officer